CHAPTER 7: BUSINESS MODELS

Question 1

Business Model Overview

Answer 1

Importance of a Business Model:

1. Helps analysts understand company operations, strategy, target customers, key partners, prospects, risks, and financial profile.
2. Conventional Business Models:

Easily understood examples: manufacturer, wholesaler, retailer, restaurant chain.

3. Impact of Digital Technology:

Changed operations and disrupted existing business models.
Led to the development of complex, specialized, or new business models.

Question 2

What Is a Business Model?

Answer 2

Describes how a business is organized to deliver value to its customers.

Includes details on customers, service methods, key assets, suppliers, and supporting business logic.

1. Purpose:

Explains what the company does, how it operates, generates revenue, and profits.

Highlights differences from competitors.

2. Details:

Provides basic relationships between key elements.

For a full description, refer to a business plan (e.g., detailed financial forecasts).

Question 3

Key Components of a Business Model:

Answer 3

1. Value Proposition:

Attributes of products or services valued by target customers.
Leads customers to prefer the firm’s offerings over competitors.
Consideration of relative pricing.

2. Value Chain:

Structure of the firm to deliver value.
Systems and processes that create value for customers.

Question 4

Key Questions for Analysts

Answer 4

Target Customers:

Who are the firm’s target customers?
How does the firm keep its customers?
Offerings:

What product(s), service(s), or experience(s) does the firm offer?
How does it differentiate its offerings from competitors?
Sales and Distribution:

Where is the firm selling?
How does it reach its customers?
Pricing:

How much is the firm’s offer pricing relative to competitors?
Is the pricing strategy effective in attracting and retaining customers?
Organization and Execution:

How is the firm organized to execute its business model?
Does the firm have competitive capabilities to sustain its operations?
Financial Impact
Revenue Model:

How does the firm’s business model impact its revenue generation?
What are the main sources of revenue?
Cost Structure:

What is the cost structure of the firm?
How does it manage its costs?
Profitability:

What is the firm’s profitability?
How does the business model contribute to profit margins?
Asset Profile and Financial Structure:

What is the firm’s asset profile?
How is the financial structure supporting its operations and growth?

Question 5

Business Model Features

Answer 5

Channel Strategy

Function: Selling/display. Handling inquiries. Order processing. Physical distribution. After-sale service

Assets: Warehouses, Retail stores, Sales force, E-commerce website

Firms: Retailers, Wholesalers, Agents, Franchisees,

Customers, Market: Who: Customers For Whom?
A. Geography
B. Segment(s)
C. Business (B2B) Retail (B2C)

Firm Offering: What: Offering What?
Product(s) Service(s)
A. Differentiation
B. Customer Needs
C. Channels: Where

Channels Where/How?
A. Direct (Physical)
B. Intermediary
C. Digital

When evaluating a firm’s channel strategy:

Distinguish between functions performed and assets involved.

Consider different firms that may be involved in these functions or own related facilities.

Question 6

Channels: Where

Answer 6

Traditional Channel Strategy:

Flow of finished goods:

Manufacturer → Wholesaler → Retailer → End customer

Common in many product businesses.

1. Direct Sales Strategy:

Manufacturer sells directly to the end customer, bypassing distributors and retailers.
Involves the company’s own sales force.
Historically expensive but cost-effective with e-commerce.

2. Intermediaries:

Some intermediaries work on an agency basis, earning commissions without taking ownership of goods (e.g., auctioneers like Sotheby’s).

3. Drop Shipping:

In e-commerce, goods are shipped directly from manufacturer to end customer without inventorying them.

4. Omnichannel Strategy:

Utilizes both digital and physical channels to complete sales.
Example: “Click and collect” where customers order online and pick up in-store.

5. Competitive Strategy:

Understanding how a firm’s channel strategy differs from competitors is crucial.
Example: Tesla’s direct sales strategy vs. traditional franchised dealer model in automotive industry.

Question 7

EXAMPLE 1

Adidas Business Model
Adidas is the world’s second largest sportswear brand. The following excerpt from the 2019 Adidas annual report (www.adidas-group.com/media/filer_public/ a8/5c/a85c9b8e-865b-4237-8def-8574be243577/annual_report_gb-2019_en.pdf) provides a brief summary of its channel strategy:
With more than 2,500 own-retail stores, more than 15,000 mono-branded franchise stores and more than 150,000 wholesale doors, we have an unri- valed network of consumer touchpoints within our industry. In addition, through our own e-commerce channel, our single biggest store available to consumers in over 40 countries, we are leveraging a consistent global framework.
1. List and number the channels used by the Adidas business model.

Answer 7

Adidas Business Model Channels:

Own-Retail Stores
Mono-Branded Franchise Stores
Wholesale Doors
E-commerce Channel

Question 8

KNOWLEDGE CHECK

1. The Tesla and Hyundai no-dealer models are examples of an established distribution channel.
2. A customer looking to buy a new car might do research online and enter her contact details in order to obtain product information; those details are a “customer lead” that is forwarded to a nearby dealer who might offer a test drive. Identify the channel strategy used in this business model.
   A. “Bricks and mortar”
   B. Third party
   C. Omnichannel

Answer 8

C.

DIRECT SALES or Dis-intermediating

Question 9

Pricing How Much?

Answer 9

Determines if the firm prices at a premium, parity, or discount relative to competitors.
Justifies its pricing based on differentiation in its business model.
Reflects the firm’s pricing power in the market.

Question 10

Pricing How Much?

Answer 10

Companies can be classified into price takers and price setters based on their pricing power.
Price takers: Accept market prices, focus on cost advantage (e.g., Walmart).
Price setters: Command premium pricing due to high differentiation.

Question 11

Pricing approaches:

Answer 11

Value-based pricing: Sets prices based on perceived customer value (e.g., Tesla’s total cost of ownership).
Cost-based pricing: Sets prices based on incurred costs (e.g., hourly rates for professional services).

Question 12

Price Discrimination

Answer 12

Price Discrimination: Charging different prices to different customers to maximize revenue.

Strategies include tiered pricing, dynamic pricing, and auction/reverse auction models.

Question 13

Pricing for Multiple Products:

Answer 13

Bundling: Combining products/services to encourage purchase (e.g., cable TV and internet).
Razors-and-blades pricing: Selling a product at a low price and its consumables at a high margin.
Optional product pricing: Offering additional features or services at a price.

Question 14

Pricing for Rapid Growth:

Answer 14

1. Penetration pricing: Sacrificing margins to gain market share (e.g., Netflix subscriptions).
2. Freemium pricing: Offering basic services for free, with premium options for a fee (e.g., mobile apps).
3. Hidden revenue business models: Providing free services while generating revenue from other sources (e.g., media with free content and paid advertising).

Question 15

Business Organization and Capabilities: How

Answer 15

Value Chain: Refers to the internal systems and processes within a firm that create value for customers. It includes activities that add value but may not involve physical product handling.

Differentiation from Supply Chain: While a value chain focuses on activities within a single firm that create value, a supply chain encompasses all processes involved in creating and delivering a product, both internal and external to the firm.

Value Chain Analysis: Links a firm’s activities to its value proposition and profitability by:
Identifying specific activities performed by the firm.

Estimating the value added and costs associated with each activity.

Identifying opportunities for competitive advantage.

Question 16

Profitability and Unit Economics

Answer 16

Profit Generation: A business model should specify how a firm expects to generate profits, considering margins, break-even points, and unit economics.

Unit Economics Examples:

A. Producer of bottle caps: Sells at 2.5 cents per unit, with direct costs of 2.0 cents per unit, yielding a contribution margin of 0.5 cents per unit. Fixed costs are USD 500,000/year.

B. Restaurant chain: Average order EUR 50, ingredient costs 50% of sales, fixed costs EUR 250,000 annually per outlet. Calculates unit break-even point and operating margin at 20,000 orders per year.

Question 17

Business Model Types

Answer 17

Industry-Specific Business Models:

Goods-Producing Sectors: Easily classified based on their position in the supply chain (e.g., manufacturers, wholesalers, retailers).
Service Businesses: More diverse, with varied business models in sectors like financial services.

Question 18

Financial Services Business Models: Include:

Answer 18

Lending and deposit-taking
Insurance
Payment processing
Brokerage
Trading
Merchant banking
Asset management
Combinations thereof (e.g., universal banks, discount brokers)

Question 19

Alternatives to Ownership

Answer 19

Recurring revenue/subscription pricing:
Enables renting a product/service (e.g., TV channels, telecom services).

1. Fractionalization:
   Sells assets in smaller units or shares use over time (e.g., web hosting, co-working spaces).
2. Leasing:
   Shifts asset ownership to reduce capital and maintenance costs (e.g., real estate, aircraft).
3. Licensing:
   Grants access to intangible assets for royalty payments (e.g., brand names, patented formulas).
4. Franchising:
   Extends rights to sell/distribute products/services in a specified area with support (e.g., fast-food chains).

Question 20

Value Proposition

Answer 20

1. Product itself:
   Attributes like performance, features, and style.
2. Service and support:
   Includes access to repairs, spare parts, etc.
3. Sale process:
   Factors like purchasing convenience and hassle-free returns.
4. Pricing relative to competitors:
   Whether the pricing is at a premium, parity, or discount compared to competitors.

Question 21

Example 2: HD Tools Business Model Consideration

Answer 21

Business Model A:

Customer Segment: Apartment dwellers, new homeowners.
Product: Simple, low-priced tool kit.
Channel: Online or mass retailers.
Customer Profile, Need: Tools for occasional use, affordability.
Relative Pricing: Low and affordable.
Customer Value: Convenience, basic functionality.
Service Expectations: After-sales support less critical.

Business Model B:

Customer Segment: DIY/professional trades.
Product: Full assortment of high-quality tools.
Channel: Home improvement stores, specialty distributors.
Customer Profile, Need: Heavy use, high-quality tools.
Relative Pricing: Premium priced.
Customer Value: Durability, performance.
Service Expectations: Demand for high-quality performance

Question 22

Business Model Types

Answer 22

1. Goods-Producing Sectors: Easily classified based on their position in the supply chain (e.g., manufacturers, wholesalers, retailers, suppliers).
2. Service Businesses: More diverse; examples include various models in the financial services sector, such as universal banks and discount brokers.

Question 23

Business Model Innovation

Answer 23

1. Impact of Digital Technology:
   Location Independence: Customers can buy from firms without a physical presence.
2. Easier Outsourcing: Digital tools facilitate easier collaboration and outsourcing.
3. Digital Marketing: Cost-effective methods to reach specific customer groups globally.
4. Network Effects: Enhanced and accessible, influencing business dynamics

Question 24

Business Model Variations:

Answer 24

1. Private Label or Contract Manufacturers (CMPL): Produce goods marketed by others.
2. Licensing Arrangements: Produce products under someone else’s brand for a royalty.
3. Value Added Resellers: Distribute products and provide installation, customization, or support.
4. Franchise Models: Distributors or retailers with a tightly defined relationship with the parent company.

Question 25

E-Commerce Business Models:

Answer 25

1. Affiliate Marketing: Earns commission from sales on other websites (e.g., CJ Affiliate). 2. Marketplace Businesses: Connects buyers and sellers without owning the goods (e.g., eBay). 3. Aggregators: Re-market products and services under their own brand (e.g., Uber).

Question 26

Network Effects and Platform Business Models

Answer 26

Network effects refer to the increase in value of a network as more users join. This concept is crucial for internet-based businesses like social media platforms, ride-sharing services, and online marketplaces. Types of Network Effects: 1. Multi-sided: Involves two or more distinct groups of users (e.g., buyers and sellers on a marketplace). 2. One-sided: Users form a single, homogeneous group.

Question 27

Platform Business Models:

Answer 27

Defined by their reliance on network effects where the value of the service or product increases with more users. Differ from traditional linear businesses where value is created within the firm.

Question 28

Crowdsourcing Business Models:

Answer 28

Crowdsourcing models enable direct user contributions to products, services, or online content. Examples: Platforms like Wikipedia, Google Maps, and Tripadvisor leverage crowdsourcing for content creation and enhancement.

Question 29

Hybrid Business Models

Answer 29

Hybrid models combine aspects of both platform and traditional linear businesses. Example: Tesla operates a linear model in selling cars but benefits from a platform aspect through its network of charging stations, enhancing customer experience and accessibility.

Question 30

LO. Describe key features of business models.

Answer 30

A business model describes how a business is organized to deliver value to its customers: 1. who its customers are, 2. how the business serves them, 3. key assets and suppliers, and 4. the supporting business logic. A business model should have a value proposition and a value chain. 1. The firm’s “value proposition” refers to the product or service attributes valued by a firm’s target customer that lead those customers to prefer a firm’s offering over those of its competitors, given relative pricing. 2. The firm’s “value chain” refers to how the firm is structured to deliver that value. It refers to the systems and processes within a firm that create value for its customers. A firm’s channel strategy refers to “where” the firm is selling its offering and how it is reaching its customers. Firms may employ a traditional channel strategy using wholesalers and retailers or a direct sales strategy selling directly to end customers. An omnichannel strategy refers to using both digital and physical channels to complete a sale. Pricing is a key element of business models. Based on pricing power companies can be classified into price takers and price setters. Pricing approaches are typically value based or cost based.

Question 31

LO: To understand the profitability of a business, the analyst should examine margins, break even points and unit economics (which is expressing revenues and costs on a per unit basis).

Answer 31

LO: Describe various types of business models. Business models types: Each industry tends to has its own set of established business models. Firms in the goods producing sectors are generally easy to classify based on how they fit into the supply chain. However, service businesses are more diverse. Digital technology has enabled significant business model innovation, often based on network effects

Question 32

Which of the following is not part of the value proposition of firm? A Product or service attributes B Target customers and offer pricing C Systems and processes within a firm

Answer 32

C is correct. The firm’s “value chain” refers to the systems and processes within a firm that create value for its customers. It refers to how the firm is structured to deliver that value. A and B are not correct. The firm’s “value proposition” refers to the product or service attributes valued by a firm’s target customer that lead those customers to prefer a firm’s offering over those of its competitors, given relative pricing.

Question 33

A firm willingly sacrifices margins to build scale and market share. Which pricing model is it most likely using? A Freemium pricing B Penetration pricing C Hidden revenue pricing

Answer 33

B is the correct. A firm, using penetration pricing, willingly sacrifices margins in order to build scale and market share. For example, Netflix subscriptions, Amazon e-readers. A is not correct. Freemium pricing model allows customers a certain level of usage or functionality at no charge. For example, mobile games, software applications. C is not correct. Hidden revenue business models provide free services to users while generating revenue elsewhere. For example, media sector which provides free content and paid advertising.

Question 34

Which of the following statements is least accurate about a firm’s value chain? A A firm’s value chain is the same as its supply chain. B A value chain includes only those functions performed by a single firm. C Some of the functions in a value chain may be valued by customers but may not involve physical transformation or handling the product.

Answer 34

A is correct. A firm’s value chain is different from a supply chain. A supply chain refers to the sequence of processes involved in the creation of a product, both within and external to a firm. It includes all steps involved in producing and delivering a product, regardless of whether those steps are performed by a single firm. B and C are true statements about a firm’s value chain.

Question 35

Which of the following is the closest example of a one-sided network? A Air BnB B Venmo C Uber

Answer 35

B is correct. Venmo is an example of one-sided network because its users are a single, homogeneous group. A and C are examples of multi-sided networks which are applicable to two or more groups of users. For example, Airbnb connects people who want to rent out their property with people who are looking for accommodations in specific locations. Uber matches vehicle owners with surplus carrying capacity with customers who need to go places not well served by public transportation or conventional transport.

Question 36

The business model of Tesla would be best described as a: A linear business model. B crowd sourcing business model. C hybrid business model.

Answer 36

C is correct. Tesla employs a hybrid model that combines platform and traditional “linear” businesses. It sells cars via a linear model, but its customers benefit from an expanding network of charging stations. A is not correct because, with a linear business, value is added by the firm; with a platform business, value is created in the network, outside the firm. B is not correct because crowdsourcing business models enable users to contribute directly to a product, service, or online content. For example, Wikipedia, Google Maps, Tripadvisor.

Question 37

The business model of a company which manufactures a product using someone else’s brand name in return for a royalty would be best described as a: A licensing arrangement. B value added reselling. C franchise model.

Answer 37

A is correct. Under a licensing arrangement, a company will produce a product using someone else’s brand name in return for a royalty. For example, toys and apparel based on famous film characters. B is not correct because value added resellers not only distribute a product but also handle more complex aspects of product installation, customization, service, or support. For example, heating/air conditioning systems resellers. C is not correct because, in case of franchise models, distributers or retailers have a tightly defined and often exclusive relationship with the parent company.

Question 38

BREAKEVEN POINT

Answer 38

FC/CONTRIBUTION MARGIN FC/SP-VC FC: Fixed Cost SP: Selling Price VC: Variable Cost CM: Contribution Margin= SP-VC